FEATURE ARTICLE, OCTOBER 2008

HOTELS & 1031s
Exchange status quo for growth opportunity.
Rosa Esqueda

Esqueda

Amidst the negative press regarding higher vacancy rates during the first half of 2008, savvy hotel investors are quickly developing new business strategies to leverage their existing investments into growth opportunities. These hotel investors realize the buying opportunities are ripe for managing turnaround investments during the next few years. A key component of a hotel investor’s growth strategy is utilizing Section 1031 of the IRS Code. Upon the sale of an investment or business property, Section 1031 allows up to 100 percent deferral of the capital gains tax, plus the accumulated depreciation recapture. Tax deferment preserves and enhances the investment portfolio by exchanging up into larger investment properties or diversifying into multiple investment properties.

Many hotel investors use 1031 exchanges to accomplish real estate investment objectives such as portfolio adjustment (expansion, diversification or consolidation), improved cash flow, and increased return on investment, reduced property management obligations or geographic relocation. Whatever the goal, more and more investors are finding that a 1031 exchange is an attractive alternative to a taxable sale followed by a purchase.

For a 1031 exchange to be successful, investors exchanging hospitality property should be aware of certain requirements particular to multiple asset dispositions. In general, any type of U.S. real property/fee simple interest held by the investor for productive use in a trade or business or for investment purposes can be exchanged for another U.S. real property interest regardless of its grade or quality, so long as it is considered fee simple real property under the state law in which it is located.

Hospitality investors naturally think of 1031 exchanges as exchanging one operating property for another. However, the IRS takes the position that while a single transaction, there may be different kinds of properties to exchange. The investor must be sure they are exchanging like-kind real property for another like-kind real property, and, similarly, personal property must also be exchanged for like-kind or like-class personal property. While creating multiple exchange groups may be complex to document and track, investors generally achieve the same tax benefit provided they are trading up or equal in value within the same property type and reinvesting the net exchange funds into the newly acquired properties.

Exchanges of hospitality properties involve unique identification issues unless the tangible personal property is less than 15 percent of the larger asset and incidental to the same. Each piece of real and personal property will need to be separately identified under what is known as the 200 percent rule. In addition to meeting the certain other requirements regarding timeliness and manner of identification, a replacement property identification involving personal property must provide an unambiguous description of the particular type of property. For example, a truck is unambiguously identified if it is described by a specific make, model and year (notably a VIN is not required). Treasury regulations do not provide many examples on proper identification of personal property; however, the burden of proof is on the investor to show that the acquired property is substantially the same as what was identified.

In the past decade, cost segregation studies have grown in popularity due to the investor’s significant cash flow benefit. The study identifies and allocates depreciation deductions often at an accelerated rate of 5, 7 or 15 years. Although it does not create new deductions, the study allows the investor to take more of the deductions sooner that otherwise might have taken 27.5 or 39 years to fully depreciate.

After these deductions, the investor is left with a significantly lower adjusted basis of their assets. In a subsequent disposition, a portion of what would otherwise have been §1250 property with unrecaptured gain taxed at 25 percent in the case of an individual investo, will now be §1245 property (as a result of cost segregation), and recapture of depreciation of the same will be taxed at the individual’s presumably higher ordinary income rate.

In summary, in the case of a long-term investor that decides to sell a building it previously depreciated pursuant to a cost segregation study, the gain allocable to depreciation of §1245 property is typically taxed at the ordinary income rate, the §1250 building depreciation recapture would be taxed at 25 percent and the gain attributable to increase in value would be taxed at 15 percent at the federal level provided it qualified for long-term capital gains treatment. State taxes, which vary, would also be applicable. However, if the investor exchanges into like-kind property, rather than an outright sale, this tax may be deferred provided that sufficient like-kind (including sufficient Section 1245) property are identified and acquired. The result is an increase in cash flow and buying power as funds that would otherwise have been consumed by taxes can be applied toward replacement property.

Cost segregation and IRS Section 1031 are two of the most valuable tax planning strategies available to hotel and other commercial real estate owners today. Through proper tax planning, both tax deferral techniques can be used on the same properties in order to obtain and preserve the maximum tax benefits. 

Rosa Esqueda is a vice president and regional manager for LandAmerica 1031 Exchange Services in Los Angeles.

Note: LandAmerica and its employees do not provide tax or legal advice. The content provided herein is general in nature and should not be acted upon without further guidance from your tax counsel.

©2008 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.